For those of you who thought that the spotlight on environmental, social and governance (ESG) reporting would fade alongside the economic turmoil of the COVID-19 pandemic, think again!
The coming years are seen by many as an opportunity to rebuild the economy with ESG reporting at the forefront. So, registrants, gone are the days when ESG efforts were merely a public relations tactic and you could get away with promising without delivering. Nowadays, ESG is a business and market imperative in many industries, making it important for your corporate management and boards of directors to understand that, even without a mandatory ESG disclosure regime, the lack of transparency and accountability when it comes to ESG reporting could leave you vulnerable to major financial, operational, and reputational risks.
The “E” in “ESG” includes, for example, pollution, energy usage, water usage, and climate oversight; the “S” covers executive compensation practices, human rights, worker safety and diversity and inclusion, among other social issues; and the “G” includes governance factors such as disclosure practices, board diversity, succession planning, and cybsersecurity. Reporting on your performance in relation to these ESG metrics can help you better manage your risks—through proactive compliance and enhanced disclosures tailored to your business—and address threats before they crop up. Let’s say, for example, that one of your compliance objectives involves reporting the energy risk that you face on account of potential price hikes. A proactive compliance approach may call for enhanced disclosures outlining a backup plan along with the specific steps that you intend to take to offset the rising prices. It may also call for your management to use the disclosures as a roadmap for addressing the threat.
Why bother with ESG reporting?
You may be wondering whether ESG reporting is even worth the hassle given the absence of a mandatory disclosure framework. The answer is yes because through risk mitigation, it can help create and protect your long-term growth. Remember, ignoring risks can lead to ESG-related events ranging from company-made environmental disasters, product-safety issues and corporate wrongdoing to lack of access to financing, reduced profits, lower stock performance, and public stigma. And let’s not forget that these days, you’re accountable to a wide range of stakeholders—including governments, regulators, shareholders, customers, employees, suppliers and communities—many of whom are demanding transparency in your approach to ESG issues. This heightened scrutiny isn’t likely to let up anytime soon.
1) New administration and ESG
With the transition from the Trump to the Biden administration, we’ve seen a major shift in attitudes around climate change and diversity, equity and inclusion (DEI) matters. During the prior administration, we witnessed the dismantling and rolling back of many policies governing air and water pollution, drilling, wildlife, and toxic substances, but President Biden didn’t waste any time restoring environmental protections. In his first days in office, he signed several executive orders that, among other things, brought the US back into the Paris Climate Agreement and revoked a permit for the development of the controversial Keystone XL oil pipeline.
Recently, on May 20, 2021, President Biden signed another executive order, starting a narrative around the US federal government incorporating climate-risk, and other ESG, factors into financial system regulation.
The Biden administration considers improved ESG reporting disclosures as an important response to risks posed by climate change and also sees broader ESG regulatory reforms occurring over the next several years.
2) SEC’s heightened ESG scrutiny
Effective November 9, 2020, the SEC adopted modernizing amendments to corporate reporting in Final Rulemaking Release No. 33-10825, Modernization of Regulation S-K Items 101, 103, and 105, by adding ESG disclosure topic human capital management (HCM), intended to cover material “measures or objectives that address the attraction, development, and retention of personnel” (available on Thomson Reuters Checkpoint, together with the SEC guidance discussed herein).
Since then, there’s been a flurry of ESG reporting-related SEC guidance:
- On December 1, 2020, the ESG Sub-committee of the Asset Management Advisory Committee recommended that “material ESG risks be disclosed in a manner consistent with the presentation of other financial disclosures … including … integrating ESG disclosures into required SEC filings and reports.”
- On February 24, 2021, then Acting Chair Allison Herren Lee released a public statement, directing Division of Corporation Finance Staff to enhance its focus on climate-related disclosure in public company filings, particularly asking the Staff to consider companies’ compliance with previously issued SEC guidance and current disclosure requirements.
- On March 3, 2021, the Division of Examinations announced its 2021 priorities, upping its focus on climate-related risks, including disclosures by funds marketed as ESG funds.
- On March 4, 2021, the SEC announced the creation of the Climate and ESG Task Force in the Division of Enforcement, whose focus is to “identify any material gaps or misstatements in issuers’ disclosure of climate risks under existing rules … [and] analyze disclosure and compliance issues relating to investment advisers’ and funds’ ESG strategies.”
- On March 15, 2021, the SEC invited public comments on climate change disclosures, including a series of questions to be considered when evaluating disclosure rules “with an eye toward facilitating the disclosure of consistent, comparable, and reliable information on climate change.” Some of the questions ask about (1) the advantages and disadvantages of drawing on the Sustainability Accounting Standards Board (SASB), the Task Force on Climate-related Financial Disclosures (TCFD), or other third-party, voluntary frameworks; (2) whether to disclose the connection between executive compensation and climate change risks and impacts; (3) the advantages and disadvantages of developing a single set of global standards applicable to companies around the world; and (4) how climate-related disclosures pertain to the broader spectrum of ESG disclosure issues.
For those of you wondering whether the guidance above changes your ESG reporting obligations and compliance efforts, consider these implications:
- First, while the guidance doesn’t relate to any new rules requiring compliance, consider it a reminder that existing rules and regulations apply in the ESG context. For example, remember that ESG information—to the extent it’s material to an understanding of your business—must be disclosed like any other material information. With that said, you may want to evaluate the effectiveness of your disclosure controls and procedures as they relate to ESG disclosures and take a fresh look at which committees are involved in the process besides the audit committee.
- Second, what’s lacking when it comes to ESG disclosures is a consistent standard of specificity to apply, as they’re often marked by selective information and a lack of transparency. For example, the SEC’s new rule on disclosure related to HCM introduces the topic of HCM generally and references a generic metric of number of persons employed instead of more useful metrics like turnover and full-time vs. part-time vs. contingent workers. As another example, many climate-risk disclosures use broad terms instead of including specific impacts, risks and opportunities related to climate change, as illustrated in the energy-risk example discussed earlier.
- Third, to better understand what the SEC expects when it comes to ESG reporting disclosures, you should consider reviewing related SEC comments and companies’ responses to see how others are addressing these comments and, perhaps, avoid potential pitfalls.
As you can see, the change in tone towards ESG is loud and clear. Though the process for any new SEC rulemaking on ESG reporting may extend to late 2021 or even later, enhanced disclosures are expected until such time as mandatory disclosures arise.
3) Potential impact of new European ESG rules on American businesses
Effective March 10, 2021, banks, hedge funds, private-equity firms, pension funds and other asset managers are obligated to comply with Europe’s new Sustainable Finance Disclosure Regulation (SFDR), with its sustainability-related transparency mandates that require disclosure of the potential harm that investments could have upon the environment and society.
For those of you thinking that you’ve dodged a bullet simply by virtue of being an American company, you’re sorely mistaken. If you’re an American company that falls into one of the following buckets, you may find yourself having to disclose how sustainability risks are integrated into your firm’s investment decisions and advice, and having to comply with additional reporting and disclosure requirements designed to prevent you from holding out a product as having sustainable characteristics when that’s not the case (a/k/a greenwashing):
- You actively market funds in the EU.
- You provide portfolio management and/or investment advisory services to EU firms that are subject to SFDR.
So, registrants, if you’re an American fund company that’s competing with European companies for shareholders, it might behoove you to follow the lead of Ares Management, Apollo Global Management and others that are evaluating the ramifications and business impact of SFDR compliance (see SECPlus Filings Highlight (“Highlight”), Ares Management and Others Express Concerns Regarding Business Impact of EU ESG Disclosure Regulation, dated April 5, 2021 and available on Thomson Reuters Checkpoint, together with the other Highlights referenced herein). Otherwise, you may be overlooked by shareholders interested in sustainable companies engaged in transparent ESG reporting.
4) ESG investor pressures
Though investor pressure on companies is nothing new, investors seem to be focusing more and more on companies’ ESG reporting efforts. As you might imagine, a proactive approach to addressing ESG issues can help keep investor pressures at bay.
Moody’s and Unilever, for example, were amongst the first companies to respond to their stockholders’ growing interest in climate-related resolutions by putting before them a non-binding, advisory say on its climate plan at their 2021 annual stockholders’ meeting, and their efforts received overwhelming stockholder support (see Highlight, Moody’s and Unilever Receive Overwhelming Shareholder Support for Their “Say-on-Climate” Resolutions, dated May 14, 2021).
On the other hand, it took getting caught in the crosshairs of investor activism for UBS Group, Barclays, Exxon Mobil and others to disclose their commitment to joining the net-zero movement in line with the Paris Agreement (see, for example, Highlight, UBS Group and Others Ramp Up Environmental Pledges, dated March 19, 2020).
Another investor talking point these days relates to third-party civil rights audits. Shareholders at various companies, including Johnson & Johnson, Citigroup and Amazon, are calling for disclosures around in-depth reviews of the impact of corporate policies, practices, products and services on the perpetuation of systemic racism (see Highlight, Shareholders at Johnson & Johnson and Other Companies Call for Racial-Equity Audits, dated April 15, 2021).
For more topics of discussion high on investors’ agendas, see my blog post titled What will shareholder activism look like in the COVID-19 era?.
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